Categories: General Market Commentary / Precious Metals
Topics: General Market Commentary / General Precious Metals

Gold-Stock Inflection Nears by Adam Hamilton

The gold miners' stocks remain deeply out of favor, largely shunned by traders. Since this sector just spent the better part of a year grinding sideways, such bearish sentiment isn't surprising. But with a giant technical formation nearing a major inflection point, things look to be coming to a head in gold-stock land. A big breakout is nearing, and gold stocks' deep undervaluation relative to gold argues it will be to the upside.

Every investor's portfolio should always include a core position in gold bullion. As a rare asset that tends to move counter to stock markets, gold acts like insurance. It rallies strongly when stocks and bonds are falling in serious corrections or bear markets, mitigating overall portfolio losses. Gold certainly has risks of its own, but they pale in comparison to the additional layers of risk heaped on by gold-mining stocks.

Gold miners face major financing, operational, geological, and geopolitical risks that gold doesn't. Even when gold is thriving on strong investment demand, individual gold miners' stocks greatly underperform if their mines suffer troubles. Thus gold-mining stocks must offer ultimate returns well beyond gold's own, to compensate investors for bearing these miners' big additional risks stacked on top of gold's own risks.

Miners' gains do amplify gold's underlying gains during gold bulls, as evidenced in the flagship HUI gold-stock index. Gold stocks' last secular bull ran for 10.8 years between November 2000 to September 2011. During that span the HUI skyrocketed 1664.4% higher, driven by gold's own parallel 602.9% bull market! That made for 2.8x upside leverage for gold stocks relative to gold, right in line with historical ranges.

The major gold stocks that dominate the HUI and the leading GDX VanEck Vectors Gold Miners ETF will generally enjoy 2x to 3x upside leverage to gold in bull markets. With the big gold stocks tending to see ultimate gains doubling or tripling gold's, investors are often willing to shoulder their additional risks. And among the smaller mid-tier and junior gold miners, their collective upside leverage to gold runs even greater!

The reason investors are so down on gold stocks today is their year-to-date leverage to gold has been horrendous. Despite the Trumphoria-fueled record-high stock markets, gold has still surged 11.9% since 2017 dawned. Incidentally that has handily bested the S&P 500's 8.7% YTD gain. But despite gold shining, the gold stocks as measured by the HUI were only up 11.1% YTD as of the middle of this week.

And that was even after Tuesday's surge, where the HUI blasted 6.1% higher on gold challenging $1300 again! The gold miners' stocks, despite their big additional risks, are actually lagging gold so far this year with terrible leverage of 0.9x. That's why bearishness on this sector is so extreme today. Truly the risky gold stocks aren't worth owning if they fail to generate much-greater gains than gold. Upside leverage is critical.

While this year-to-date snapshot is pretty damning, it's a myopic perspective. Like everything else in the markets, gold stocks' leverage to gold flows and ebbs in cycles. We are likely at trough leverage now, as it's hard to imagine this sector's psychology becoming much worse. After exceptional underperformance relative to gold, the gold stocks' gains tend to surge and outperform to gradually restore that 2x to 3x average.

Given the sometimes-extreme cyclicality of gold stocks' upside leverage to gold, they were actually due for a period of underperformance. In January 2016, a new gold-stock bull was born out of fundamentally-absurd13.5-year secular lowsin HUI terms. Over the next 6.5 months, the gold stocks soared 182.2% higher on a new and small 25.2% gold bull. That was extreme 7.2x upside leverage, far too great to be sustainable.

I warned about gold stocks' excessive early-bull gains last July, that a mid-bull correction was necessary and inevitable to rebalance sentiment. Due to a series of anomalous events slamming gold itself in the second half of last year, that healthy gold-stock correction grew far more extreme than anyone expected. But after such huge outsized gains relative to gold in 2016's first half, a leverage mean reversion is righteous.

So the gold stocks have far-underperformed gold for the better part of a year now, fully bleeding off the excessive greed their early-2016 outperformance fueled. And now the relative-performance pendulum is once again set to swing back the other way. This chart looks at the major gold miners' technicals since early 2016 as represented by the HUI. A major triangle consolidation chart pattern is nearing the end of the line.

That overdue gold-stock correction last summer was fast and furious in August, with the HUI plunging a blistering 22.0% in less than a month! That was totally normal. The gold stocks then spent September consolidating and bottoming, typical staging for their next upleg. But then out of the blue they got walloped by an extreme event. Gold futures suffered a mass stopping as key gold support near $1300 failed to hold.

Gold's resulting extreme 3.3% down day in early October sucked in the gold stocks, which saw their own stop-loss-triggered cascading selling. The HUI plummeted 10.1% in a single trading day, spawning incredibly-bearish psychology! But that September consolidation before the early-October plunge would start forming the upper resistance line of the giant triangle consolidation pattern finally nearing maturity today.

After that extreme anomaly, the gold stocks soon started grinding higher again along the HUI's key 200-day moving average. 200dmas are usually the strongest support lines in ongoing bull markets. Then unbelievably gold suffered anotherextreme anomaly. After Trump's surprise election win, stock investors started jettisoning gold-ETF shares like crazy on the sharp Trumphoria stock-market rally. Gold plunged again.

And naturally the HUI followed, as gold miners' profits and hence ultimately stock prices are leveraged to underlying moves in gold prices. After that the gold stocks started consolidating again in November, until they were hit by a mind-boggling third anomalous event after just suffering two in two months. The gold stocks dropped with gold in mid-December on 2017 Fed-rate-hike projections being more hawkish than expected.

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